Bubble Bubble Mortgage Trouble

Global equity, currency, interest-rate, and commodity markets remain quite
choppy. Technology issues led U.S. stocks this holiday-shortened week. For
the week, the Dow gained 0.5% and S&P500 added 0.9%. The Transports were
strong, rising 2.6%, while the Utilities were about flat, adding 0.1%. The
Morgan Stanley Cyclical index gained 0.3% and the Morgan Stanley Consumer fell
slightly by 0.3%. The broader market was very strong, with the small cap Russell
2000 finishing the week up 2.5% and the S&P400 Mid-cap index up 0.9%. The
NASDAQ100 advanced an impressive 3%, and the Morgan Stanley High Tech index
added 5%. The Semiconductors more than made up for last week's 6.4% loss by
rising 7.2%. The Street.com Internet Index increased 4.1% and the NASDAQ Telecommunications
added 4.9%. The Biotechs gained 1.9%. Financial stocks were mixed but generally
higher, as the Broker/Dealers added 3.6% and the banks finished the week up
0.5%. With bullion gaining $1.40, the HUI index advanced 0.6%.

September 9 - Bloomberg (Matthew Keenan): "Emerging markets bond funds had
net inflows for the fourth straight week, as concerns about rising U.S. interest
rates faded, according to Emerging Portfolio.com Fund Research. The funds had
$235.6 million in net new investments from Aug. 4 to Sept. 1, the Cambridge,
Massachusetts-based company said in an e-mailed statement. The funds, which
had outflows in 15 of the previous 17 weeks, now have $16.7 billion in assets,
EPFR said."

September 10 - Bloomberg: "A speculative mood and a high degree of liquidity
fuelled gains on Mideast stock exchanges this week and are likely to continue
to do so, financial analysts said Friday. 'Speculation and a high degree of
liquidity are believed to be the main dominant factors at this juncture,' Maher
Muasher, head of the Brokerage Section at the Ahli Bank, told Deutsche Presse-Agentur
dpa. Muasher spoke as bourses in Jordan, Saudi Arabia, Kuwait and Egypt scored
fresh advances in the trading week ending Thursday."

September 8 - Bloomberg (Hamish Risk): "The global market for credit derivatives
last year grew 70 percent to more than $2.8 trillion, fueled by increased trading
in credit-default swaps on single companies, Fitch Ratings said. Trading in
so-called single name default swaps doubled to $1.9 trillion in 2003, the New
York-based ratings company said in its annual survey of the credit-derivatives
industry. Trading of contracts based on indexes, which let investors bet on
a group of companies, increased 49 percent, the report said."

Currency Watch:

September 9 - Bloomberg: "Brazil's real rose to a 21-week high after Moody's
Investors Service raised its rating on the country's sovereign debt for the
first time since 2000. Moody's raised its foreign currency debt rating bonds
to B1, four levels below investment grade, from B2. The increase, coming after
debt sales by Brazil's government and Petroleo Brasileiro SA, the state-controlled
oil company, may spark more sovereign and corporate foreign-currency bond offerings,
said Siobhan Manning, chief emerging-market bond strategist at CAboto USA Inc.
the New York investment-banking arm of Banca Intesa SpA, Italy's largest bank."

Currency markets remain brutal. For the week, the dollar declined better than
1.5%. The Swedish krona gained 2%, while the Danish krone and euro rose 1.6%.

Commodities Watch:

Commodities markets remain exceptionally volatile. For the week, the CRB index
dipped 0.7%, lowering y-t-d gains to 6.4%. Although October crude was down
$1.18, the Goldman Sachs Commodities index was little changed on the week (up
15.2% y-t-d).

China Watch:

September 9 - Bloomberg (Allen T. Cheng): "China's investment in factories,
roads and other fixed assets rose 32 percent from a year earlier in August,
faster than the growth rate for the first seven months, said a senior government
economist. 'The figures indicate that there is a serious structural problem,'
Wu Jinglian, a researcher at the cabinet-level State Development Research Center,
said at a conference in Beijing. 'The government policies haven't been as effective
as the media has been reporting them to be.'"

September 10 - Bloomberg (Philip Lagerkranser and Tian Ying): "China's industrial
production growth unexpectedly accelerated in August, fueling speculation the
central bank will raise its benchmark interest rate for the first time in nine
years. Production rose 15.9 percent from a year earlier to 455 billion yuan
($55 billion) after climbing 15.5 percent in July, the Beijing-based National
Bureau of Statistics said..."

September 10 - UPI: "Factories in southern China are facing a labor shortage
as migrant workers seek better wages and working conditions elsewhere, a government
survey shows. The study, released this week by China's Ministry of Labor and
Social Security, said there was an estimated 10 percent labor shortage in the
Pearl River Delta, Fujian and Zhejiang provinces, where factories are most
concentrated. The Pearl River Delta alone reportedly requires an additional
2 million workers to meet present needs."

September 9 - Bloomberg: "China' exports rose 35.8 percent to $360.6 billion
in the first eight months of this year, according to International Business
Daily, a commerce ministry publication. Imports increased 40.8 percent to $361.5
billion, giving a trade deficit of $900 million, the newspaper said, citing
customs bureau figures. Total trade surged 38 percent to $722.1 billion in
the first eight months, it said."

September 9 - XFN: "China's shipbuilding tonnage is expected to reach a new
record of more than 8 million tons this year, up some 30% from a year earlier,
on the back of booming domestic and international markets, the China Daily
reported. Citing statistics released by the China Association of National Shipbuilding
Industry, the state-run newspaper said tonnage increased by 66% year-on-year
during the first half 2004 to 4.09 million tons..."

September 8 - Bloomberg (Le-Min Lim): "China's economic growth will probably
slow to 9 percent in the third quarter as government lending curbs take effect,
the official Xinhua news agency reported... The economy, Asia's biggest after
Japan, expanded 9.6 percent from a year earlier in the first half and Qi, who
works for the State Information Center, expects growth to average 7 percent
this year, the report said."

Asia Inflation Watch:

September 10 - Bloomberg (Seyoon Kim): "South Korea' government plans to increase
spending by 9.5 percent to 131.5 trillion won ($115 billion) next year, the
ruling Uri Party said... The Ministry of Planning and Budget said last week
it planned to boost spending to 132 trillion won in 2005 from 120.1 trillion
won this year. The ministry said the 2005 budget will be discussed at a Cabinet
meeting on Sept. 21 before it is submitted to the National Assembly in Seoul
for approval on Oct. 2."

September 9 - Bloomberg (Clare Cheung): "Hong Kong may fetch as much as HK$11
billion ($1.4 billion) in the Oct. 12 land auction, the biggest sale since
the height of the property boom in 1997, as developers vie for land amid a
revival in the real estate market."

September 10 - Bloomberg (Cherian Thomas): "India's industrial production
accelerated faster that expected in July as the cheapest credit in three decades
and record farm incomes boosted demand for homes, cars and other consumer goods.
Production at factories, utilities and mines rose 7.9 percent from a year earlier,
faster than the 7.5 pace in June..."

September 7 - Bloomberg (Subramaniam Sharma): "India estimates that costs
have increased a fourth on average, or a total of about $10 billion, on government
projects surveyed by the statistics ministry, mostly because of delays in completion.
The 300 projects examined, which include power plants, railway lines, fertilizer
factories and highways, will cost 2.47 trillion rupees ($53 billion) compared
with the initial estimate of 2.02 trillion rupees, the ministry said in a statement..."

September 7 - Bloomberg (Theresa Tang): "Taiwan' exports rose 20 percent in
August as the island's electronics makers shipped more flat-panel displays,
computer chips and other electronic goods. Shipments increased to $14.8 billion
after climbing 26 percent from a year earlier to $14.7 billion in July, the
Ministry of Finance said in a statement in Taipei. The government said it expects
overseas sales to rise 23 percent this quarter and 17 percent in the final
three months of the year."

September 10 - Bloomberg (Lily Nonomiya): "Japan unexpectedly cut its estimate
for second-quarter economic growth to a 1.3 percent annual pace, the slowest
in more than a year, as some manufacturers reduced inventories on concern orders
may fall. Stocks and the yen slid. The pace of growth announced by the Cabinet
Office in Tokyo was lower than the initial estimate of 1.7 percent..."

September 9 - Bloomberg (Christian Baumgaertel): "The European Central Bank
said prices for residential buildings have risen so fast in some European countries
they need 'close monitoring,' suggesting it's worried the lowest credit costs
in six decades may push up inflation. Residential property prices in the dozen
euro countries rose 7.2 percent last year, the most in a decade..."

September 10 - Bloomberg (Mark Bentley): "Turkey's gross national product,
the country's main indicator of economic output, leaped an annual 14.4 percent
in the second quarter, the fastest in at least 17 years, amid a surge in investment
and consumer pending. Consumption jumped 16 percent in the three months through
June, the State Institute of Statistics said... Investment outside of the government
sector soared 68.7 percent. Turkish growth, fueled by consumer loans and credit
card spending, is raising concern that the country's burgeoning current account
deficit may undermine the lira and boost inflation..."

U.S. Bubble Economy Watch:

September 10 - New York Times (Milt Freudenheim): "The cost of providing health
care to employees has risen 11.2 percent this year, according to the results
of an authoritative national survey reported yesterday. It was the fourth consecutive
year of double-digit increases in health insurance premiums, which has resulted
in a steady decline in the number of the nation's workers and their families
receiving employer health care coverage. The annual survey of 3,000 companies,
conducted between January and May by the Kaiser Family Foundation and Health
Research and Educational Trust, is considered a reliable indicator of health
care costs paid by companies and their workers. Small businesses are being
especially hard hit as the average family coverage in preferred provider networks,
the most common type of health plan, has risen to $10,217, with employees paying
$2,691 of the total. In response to the soaring costs, many small companies
are simply no longer offering coverage of a worker's spouse and children."

Mortgage Finance Bubble Watch:

September 10 - Countrywide Financial: "Monthly purchase activity rose for
the six consecutive month to $18 billion, an increase of 1 percent over last
month and 42 percent more than August 2003. Year-to-date purchase volume now
stands at $113 billion, approaching 2003's full year level of $130 billion...
Adjustable-rate fundings reached a record $18 billion, (up 7% from July and)
83 percent greater than August 2003, and accounted for 59 percent of total
month loan volume... Home equity funding sreached a new monthly record of $3.1
billion, 8 percent more than the previous month and 80 percent higher than
August 2003. Year-to-date home equity production surpassed $18 billion, and
exceeded the volume achieved in calendar 2003. Subprime volume grew for the
month to $4.3 billion, advancing 13 percent from last month and increasing
158 percent over August 2003." Total August fundings of $31 billion were up
5 percent from July, with y-t-d fundings of $237 billion. "Total assets at
Countrywide Bank rose to $31 billion, 8 percent higher than July 2004 and double
the level of August 2003."

September 9 - Bloomberg (Kathleen M. Howley): "U.S. mortgage delinquencies
rose last quarter for the first time in a year while foreclosures fell to the
lowest level since 2000, according to a Mortgage Bankers Association report.
The share of homeowners who paid their mortgages a month or more late rose
to a seasonally adjusted 4.43 percent, from 4.33 percent in the first quarter...
The share of loans in foreclosure fell to 1.16 percent from 1.27 percent in
the prior quarter."

Bubble Bubble Mortgage Trouble:

I wrote an article for the the Summer 2004 edition of The
International Economy, an excellent publication that I strongly
recommend. They passed on my suggested title, The Great Mortgage Finance
Bubble, but theirs will have to do.

Back in 2000, I wrote an article for The International Economy titled "The
Great Experiment." The focus of the analysis was the nuances of contemporary
finance, in particular the ramifications for unchecked growth from the government-sponsored
enterprises (GSEs). Four years later, sufficient data and observations from
this "experiment" warrant an update and further analytical examination.

From January 2000 through May of this year, Fannie Mae and Freddie Mac's combined "books
of business" (retained portfolios and guaranteed mortgage-backed securities
sold into the marketplace) have ballooned 77 percent to $3.66 trillion. Fannie
and Freddie total assets have increased 186 percent to $2.83 trillion since
the beginning of 1997, with Federal Home Loan Bank System assets up 193 percent
to $857 billion. And according to Federal Reserve "flow of funds" data, total
mortgage debt has increased 93 percent to $9.62 trillion, jumping from 61 percent
to 84 percent of GDP in seven years.

Total mortgage borrowings expanded $1.0 trillion or 12 percent last year,
with 2004 on track to surpass 2003's record. For comparison, mortgage debt
increased on average about $200 billion annually during the first eight "pre-bubble" years
of the 1990s. Total U.S. home sales are currently on track to surpass last
year's record by 10 percent, with the dollar value of housing transactions
up approximately 65 percent over three years and 100 percent from six years
ago. The nation's average (mean) price of existing homes sold has increased
28 percent over three years and 48 percent over the past six years. In California,
median home prices were up an astonishing $97,530 during the past twelve months
(through May) to $465,160. Golden State home prices have surged 46 percent
over two years, 81 percent over three years, and 129 percent over six years,
in what has developed into one of history's spectacular asset inflations.

The GSEs have played the instrumental role in the development of a historic
mortgage finance bubble. And while the GSE debate tends to concentrate narrowly
on the values of the federal subsidy and the implicit government backing of
agency debt, the broader - and crucial - issue of the consequences of a momentous
expansion of mortgage finance is neglected, if at all recognized.

Reminiscent of the late-1990s manic stock market environment, the issue "Is
housing a bubble?" has become a hot topic for the media, investment analysts,
economists, and policymakers. Federal Reserve Bank of New York economists Jonathan
McCarthy and Richard W. Peach recently published "Are Home Prices the Next
'Bubble'?" This research suggests that, in spite of significant attention directed
to the issue of asset bubbles, our central bank has made scant progress in
comprehending or addressing either asset inflation or bubble dynamics.

Messrs. McCarthy and Peach concluded that "there is little evidence to support
the existence of a national home price bubble." Yet, their article - and Federal
Reserve research generally - ignores what should be the focal points of bubble
analysis: credit growth, speculative finance, marketplace liquidity, and various
financial and economic distortions.

Analyses of the GSEs and mortgage finance should begin with an appreciation
for the extraordinary capacity of key lenders these days to issue unlimited
quantities of new liabilities (chiefly, agency and asset/mortgage-backed securities)
with no impact on the market's perception of these instrument's "Triple-A" quality
status. Indeed, it is a defining characteristic of contemporary Wall Street "structured
finance" that virtually inexhaustible quantities of risky loans can be transformed
into perceived top-quality, safe and liquid securities. This alchemy is dependent
upon a daisy-chain of explicit and implicit guarantees, credit insurance, liquidity
agreements, and the expansive derivatives marketplace. The GSEs are very much
the nucleus, while the market's faith in the Fed and Treasury to stand behind
Fannie, Freddie, and the FHLB provides the backbone of this peculiar market
structure.

From a theoretical perspective, financial evolution has attained a renown
I will refer to as the "moneyness of credit" - a pinnacle achievement conceptually
and an unexplored quandary in reality. Throughout history, faith in the relative
safety of fiat money has left it inherently susceptible to over-issuance. And
with the creep of monetary inflation comes the specter of myriad inflationary
effects, currency debasement, and progressive monetary disorder. These days,
GSE and Wall Street securities fabrication has supplanted the government printing
press as the paramount source of monetary inflation. Total "structured finance" -
combined GSE assets, along with outstanding mortgage and asset-backed securities
- has over seven years mushroomed an astonishing 126 percent to $7.46 trillion.

Traditionally, bank lending to fund business spending and investment provided
the predominant source of finance. In the process, bank loans expanded the
money supply through the creation of new bank liabilities/deposits. But no
longer do banks and their deposit "money" hold sway over either the financial
system or economy.

Financial systems have evolved profoundly. Especially over the past decade,
this evolution has radically altered the character of lending and intermediation,
along with the types of financial sector (in contrast to bank) liabilities
issued. Importantly, non-bank asset-based lending is today the commanding mechanism,
creating the liquidity that drives both financial markets and economies.

Total "structured finance" has jumped from 41 percent to 65 percent of GDP
in just seven years. During this period, total bank loans and leases rose from
35 percent to 40 percent of GDP, expanding 60 percent to $4.54 trillion (real
estate loans accounting for two-thirds of bank loan growth). Examining the
nature of lending, it should be clear that contemporary "money" is today increasingly
comprised of agency securities and agency-related instruments, along with Wall
Street structured products. "Money" is big business.

It is worth emphasizing the current historical anomaly that, domestically
as well as globally, there is no mechanism, effort, or regulatory mandate to
control either the quantity or the quality of contemporary money and credit
expansion. As such, I would argue that there is today an overriding top-down
predicament associated with contemporary finance: There exists a powerful dual
capacity and propensity for debt to be issued in excess by myriad profit-seeking
financial intermediaries. What's more, seemingly limitless profit potential
will ensure that asset markets - both real and financial - will attract the
lion's share of lending and finance. How can a limited universe of profitable
investment opportunities compete for lender enthusiasm against those available
from bountiful - and inflating - asset markets?

Throughout the lending process, the preponderance of financial-sector liabilities
created - contemporary money and credit - will be perceived to be of the highest
quality and liquidity. This "moneyness" attribute predicates virtually insatiable
demand for the underlying debt instruments, which impels lending excess, over-issuance
and self-reinforcing asset inflation.

Such inflation provides a boon to enterprising speculators, also enjoying
unparalleled access to finance as they play a decisive part in advancing self-reinforcing
asset bubbles. Mortgage finance bubble analysis includes two distinct facets
of asset speculation: Exuberant borrowing to finance home and property purchases,
as well as aggressive speculator leveraging in agency and mortgage-backed securities. "Speculator" in
this context would include the expansive hedge fund community, securities broker/dealer
proprietary trading, mutual funds, banks, insurance companies, corporate finance
departments, pension funds, and various individuals and institutions (domestic
and international) employing "carry trades," "repos," derivatives, and myriad
leveraged strategies. Evolving insidiously over time, the liquidity created
in the process of leveraged asset speculation emerges as a governing source
of finance for both the markets and the general economy - i.e., the 1990s tech/telecom
bubble and today's housing/consumption bubble. To ignore asset inflation, speculative
finance, and bubble dynamics is really to disregard the very essence of contemporary
finance and economics.

The GSEs have enjoyed virtually unbounded capacity to finance expanding asset
holdings through the issuance of perceived risk-free liabilities. Their liquidity-creating
powers have on numerous occasions proven invaluable in ameliorating acute systemic
stress. In reality if not by statute, the GSEs evolved to attain the all-powerful
status of quasi-central banks. Their aggressive expansions during the 1994
bond market dislocation, the 1998 Long-Term Capital Management debacle, the
1999 Y2K scare, and the tumultuous 2000-2002 period were certainly invaluable
in rectifying jeopardous market conditions.

Chairman Greenspan often asserts that the U.S. economy's ability to persevere
- and indeed excel - despite a series of shocks and setbacks is largely attributable
to its extraordinary "productivity" and "flexibility." Yet a strong case can
be made that any accolades should be directed foremost to the Herculean resiliency
of contemporary finance.

Above all, abundant and unabated credit and liquidity creation fueled home
price inflation. The Federal Reserve collapsed rates and orchestrated a steep
yield curve that, along with assurances of liquid financial markets, incited
unparalleled leveraged speculation. Truly unprecedented system credit expansion
underpinned buoyant asset markets: From the household and government sectors,
on the one hand, and financial sector leveraging on the other. And asset inflation
was certainly instrumental in stimulating demand to sustain the consumption
and services-based American economy.

There is another critical facet to GSE market power and influence that goes
unappreciated. As quasi-central banks intervening to stabilize the U.S. credit
market, Fannie and Freddie have attained the prominence of "buyers of first
and last resort" for speculators leveraged in mortgage-backed and other debt
securities. Repeated aggressive market interventions over the years were instrumental
in averting dislocations, and in the process enriched and emboldened the speculating
community. Why not take full advantage of a steep yield curve by leveraging
mortgage securities when Fannie and Freddie stand ready to aggressively purchase
these holdings in the event of unfolding market stress? GSE market influence
has been instrumental in nurturing the hedge fund and proprietary trading communities,
and with them the ballooning global pool of speculative finance.

Furthermore, the GSE's aggressive securities purchases - at critical junctures
circumscribing interest-rate spikes and dislocation otherwise associated with
speculative de-leveraging - have played a definitive, yet surreptitious, role
in the explosion of derivative positions. Here as well, the GSE liquidity backstop
has emboldened risk-taking and distorted the marketplace. The viability of
much of the derivatives marketplace rests on the assumptions of continuous
and liquid markets - specious premises thus far affected legitimate by unending
and timely GSE expansion.

Mushrooming derivatives markets have, in turn, played an instrumental role
in the historic ballooning of GSE and mortgage debt generally. The GSEs have
accumulated more than $1 trillion of short-term debt, while relying extensively
on derivatives to hedge a potentially catastrophic asset/liability mismatch.
On one hand, GSE interventions underpin marketplace liquidity. On the other,
the GSEs and mortgage-backed securities holders are the largest buyers of derivative
protection. Meanwhile, GSE counterparties rely predominantly on dynamic hedging
strategies, with computer hedging models calculating the quantities of securities
to buy or sell in the event of changing interest rates.

The major problem is that the larger GSE balance sheets, mortgage debt, speculative
leverage, and derivative positions balloon, the less viable this entire hedging
("portfolio insurance") mechanism becomes. It is simply not feasible for a
large segment of the marketplace to move concurrently to hedge exposure in
a rising rate environment. After all, marketplace liquidity would be inadequate
to accommodate the enormous hedging-related selling into a faltering market.
Moreover, rapidly rising rates render derivative traders and leveraged players
increasingly aggressive sellers, competing for limited and waning liquidity.
I am therefore left with the disconcerting view that the GSEs have evolved
into the linchpin for a massive mortgage finance bubble encompassing endemic
- and eventually untenable - financial sector leveraging, speculating, and
derivative trading.

Yet the ramifications of the mortgage finance bubble are anything but confined
to the financial arena. Indeed, the bubble's effects on the real economy may
very well prove the most intractable. Mortgage credit excess and asset inflation
today foster household over-borrowing and over-consumption. Investment decisions
are similarly distorted. About two million residential units will be constructed
this year, approximately 45 percent higher than the 1990s average of 1.37 million.
The ongoing multi-year construction boom also includes retail, restaurant,
hotel and gaming, sports venues, and other consumption-related structures.
Regrettably, we are witnessing a replay of the late-1990s telecommunications
and technology boom-and-bust experience, where a surfeit of speculative finance
fosters destabilizing over-spending in the "hot" sectors.

It is the very nature of speculative finance that inflated boom-time profits
seductively induce only greater speculative flows, and in the process evoke
notions of New Eras and New Paradigms. The destabilizing torrent of finance
assures systemic vulnerability to the inevitable reversal of speculative flows
(i.e. the tech bubble's stock and junk bond boom and collapse), exposing the
extent of previous uneconomic investment. The abrupt adjustment of distorted
boom-time spending patterns proves especially destabilizing - most economic
agents are caught heavily exposed and flat-footed after extrapolating the boom
far into the future. Bursting bubbles also invariably uncover significant waste
and fraud. Indeed, a confluence of factors is set in motion that rectifies
the divergence between perceived financial wealth and true economic wealth
that had become so distended during the maniacal phase of the boom.

Today, the size of the pool of speculative finance is significantly larger
than what fueled the tech bubble just a few short years ago. The housing and
the consumer sectors have become the magnets for truly momentous financial
flows. Asset inflation and associated spending and investment have evolved
to become the driving force behind heady household income growth (rising at
a 6.7 percent rate year-to-date through May!). And recalling how inflated boom-time
technology profits were extrapolated to justify gross equities overvaluation
(as well as over-borrowing), inflated household income growth is these days
used to assert the reasonableness of both inflated housing values and surging
consumer debt loads. A pernicious circularity is a work here, as sufficient
purchasing power to sustain inflated asset prices and an unbalanced economic
expansion is generated only through unrelenting and enormous mortgage borrowings.

Bubble excesses, including over-consumption and maladjusted investment, have
engendered an increasingly untenable trade position. Unrelenting U.S. current
account deficits beget dollar weakness and a swelling pool of global dollar
liquidity. Yet one is hard-pressed to glean analysis linking the GSE and mortgage
finance bubbles to ballooning U.S. foreign liabilities and destabilizing global "hot
money" flows. No less an authority than Alan Greenspan proclaims confidence
that the market pricing mechanism will function over time to innocuously rectify
U.S. imbalances.

Analysis of the nature of bubble dynamics, however, leaves one anything but
complacent. Categorically, asset bubbles require ever-increasing quantities
of credit expansion. As for housing, rising borrowings are necessary to finance
booming transaction volume and maintain inflated values. This is most conspicuous
currently with the hyper-bubble markets in California and along the East Coast.
And liquidity emanating from the mortgage finance bubble these days fuels inflated
and vulnerable financial asset prices. There is, as well, the critical issue
of bubble economies, prolonged only by escalating credit creation. The consumption,
services, and finance-based U.S. bubble economy - with huge trade deficits,
scores of uneconomic enterprises, and myriad general imbalances - is an absolute
credit and liquidity glutton.

Importantly today, inflating asset markets have evolved to become the key
mechanism for generating liquidity and income growth system-wide, rendering
the entire financial and economic system acutely vulnerable to any diminution
of credit growth.

Current complacency is understandable. The U.S. economy has indeed overcome
a series of shocks. Presuming that technology and the stock market were the
bubble, the consensus view trumpets the resiliency of the "post-bubble" U.S.
economy. The harsh reality, however, is that the tech and equity boom was only
an appendage of a mammoth bubble progressing uninhibited throughout the U.S.
credit system. Today, I would strongly argue that the credit bubble is in the
midst of its "terminal" stage of excess. Credit inflation manifestations have
turned increasingly destabilizing and difficult to manage.

It is worth contemplating that from the late 1990s through 2001, the U.S.
economy and markets were the favored destination for global investors and speculators.
The "king dollar" period was anomalous for the ease with which escalating U.S.
current account deficits were recycled back to American assets. There have
been, however, some rather momentous changes over the past couple of years.
Not only have U.S. current account deficits ballooned to historic extremes,
investor and speculator funds now flow enthusiastically to various non-dollar
markets and asset classes. The environment for recycling dollar balances has
abruptly inverted from extraordinarily favorable to increasingly problematic.

Our nation's annual current account deficit is approaching $600 billion. The
dollar has suffered a sharp two-year decline against the euro and most major
currencies, with the dollar index sinking 25 percent since 2002's first quarter.
Arguably, only unprecedented central bank dollar purchases have extricated
currency markets from the scourge of illiquidity, dislocation, and crisis.
Global central banks expanded international reserve assets by approximately
27 percent the past year to $3.25 trillion, with the major Asian central banks
increasing largely dollar reserves in the neighborhood of $545 billion, or
38 percent, to $1.97 trillion.

The consequences of this unparalleled monetary inflation include an unwieldy
boom in China and throughout Asia, rising global energy demands and prices,
manic commodities markets with examples of depleting inventories, and generally
heightened price pressures globally. Importantly, the global pricing environment
has been transformed from "dis-inflationary," to "re-flationary," to the current
distinctly inflationary. There is today, then, the issue of the consequences
of open-ended massive foreign central bank dollar support and monetization.
Going forward, central bankers will have no alternative than to weigh the competing
risks associated with ongoing dollar support and resulting inflationary effects,
versus a faltering dollar, unstable currency markets, and U.S. financial and
economic fragility.

I made the case four years ago that uncontrolled GSE excess posed a threat
to our policymakers' strong dollar policy. I today advise that the U.S. mortgage
finance bubble creates a clear and present danger to the stability of our financial
system and economy, as well as the soundness of our currency.